Letter of credit: how an LC works, step by step, with an example

A letter of credit (LC) is a bank's written promise to pay the seller, on behalf of the buyer, as long as the seller presents documents that match the LC's terms within the stated time. The seller no longer depends on the buyer's willingness to pay; it depends on the bank's undertaking and on getting the documents right. That is the whole idea, and almost every LC problem in practice comes back to one of those two points.

Why businesses use a letter of credit

In trade between parties who don't know each other well, especially across borders, each side carries a risk:

The seller (exporter) fears shipping goods and then not getting paid.
The buyer (importer) fears paying in advance and then not getting the goods, or getting them late.

An LC places a bank in the middle. The seller ships knowing a bank will pay against documents. The buyer knows the bank will pay only when documents showing shipment, as agreed, are presented. Most international LCs are issued subject to the ICC's UCP 600 rules, so banks in different countries work to the same rulebook.

The parties to an LC

Party	Who it is	Role
Applicant	The buyer / importer	Asks its bank to open the LC
Issuing bank	The buyer's bank	Gives the undertaking to pay
Beneficiary	The seller / exporter	Gets paid against documents
Advising bank	A bank in the seller's country	Confirms the LC is genuine and passes it on
Nominated / negotiating bank	Often the seller's bank	Examines documents and may pay or negotiate
Confirming bank	Optional, usually in the seller's country	Adds its own promise to pay on top of the issuing bank's

Under UCP 600, a credit is irrevocable even if it doesn't say so, and the issuing bank is bound from the moment it issues the LC. A confirming bank is bound from the moment it adds its confirmation. So once an LC is issued, it cannot be cancelled or changed without the agreement of the parties concerned.

The LC process, step by step

Sale contract. Buyer and seller agree that payment will be by LC and settle the key terms: amount, goods, shipment date, port, documents and whether payment is at sight or after a usance period.
LC application. The importer applies to its bank. The bank opens the LC within the importer's sanctioned non-fund-based limit and usually takes a cash margin, as set in the sanction.
Issue. The issuing bank sends the LC, usually as a SWIFT message, to the advising bank in the seller's country.
Advising. The advising bank checks that the LC is genuine and passes it to the seller. The seller should read every clause now; this is the cheapest time to ask for an amendment.
Shipment. The seller ships the goods and collects the documents the LC calls for, such as the invoice, bill of lading or airway bill, packing list, certificate of origin, insurance document and inspection certificate.
Presentation. The seller presents the documents to the nominated bank, within the presentation period and before the LC expires.
Examination. Banks check the documents against the LC, not against the goods. Each bank has up to five banking days after the day of presentation to decide whether the presentation complies.
Payment or acceptance. For a sight LC, the bank pays. For a usance LC, the bank accepts the draft and pays on the due date.
Reimbursement and release of documents. The issuing bank pays the nominated bank and debits the importer (or creates a liability if it isn't funded on time). The importer then gets the documents and uses them to clear the goods.

Documents, not goods

This is the rule most first-time users miss. UCP 600 says banks deal with documents and not with goods, and that the LC is a separate transaction from the sale contract. Two consequences follow:

If the documents comply, the bank pays, even if the buyer later says the goods were poor. The buyer's remedy is against the seller under the sale contract, not against the bank.
If the documents don't comply, the bank can refuse to pay, even if the goods are perfect.

Data in the documents need not be word for word identical with the LC, but it must not conflict with it. If a bank refuses, it must send a single notice listing all the discrepancies, so the presenter can fix them in one go.

Sight, usance and other types of LC

Sight LC: paid when compliant documents are presented.
Usance (deferred) LC: paid after a set period, for example 90 days from the bill of lading date. The buyer gets credit time; the seller can discount the accepted bill to get money earlier.
Confirmed LC: a second bank adds its promise. Exporters ask for this when they are unsure of the issuing bank or the buyer's country.
Transferable LC: can be passed in whole or part to a second beneficiary, but only if the LC expressly says it is transferable. Traders who buy from a supplier and sell to a customer use these.
Back-to-back LC: a trader uses an LC received from the buyer as the basis for opening a second LC in favour of its supplier.
Revolving LC: the amount gets reinstated, which suits regular shipments to the same buyer.
Inland LC: used within India between a domestic buyer and seller, under the same principles.

A worked example

A typical case: a manufacturer in Pune imports a machine from a supplier in Germany.

Term	Value
LC amount	About USD 1,50,000
Exchange rate (assumed for the example)	₹88 per USD
Rupee value	₹132 lakh (₹1.32 crore)
Cash margin (as per sanction, say)	15%
Type	Usance, 90 days from bill of lading date
Latest shipment	15 November 2026
LC expiry	15 December 2026

Margin and limit used. The bank keeps 15% of ₹132 lakh, which is ₹19.8 lakh, as cash margin. The remaining ₹112.2 lakh is the bank's exposure, and the full LC amount is marked against the importer's LC limit.

Tolerance. Because the LC says "about", UCP 600 allows up to 10% more or less. The seller can draw anything from USD 1,35,000 to USD 1,65,000, and the importer's bank should keep limit room for the upper figure.

Presentation deadline. The seller ships on 10 November 2026. The LC does not state a presentation period, so UCP 600's default applies: documents must be presented within 21 calendar days of shipment, and in any case before expiry. The deadline is therefore 1 December 2026, two weeks before the LC expires. Exporters who look only at the expiry date lose payment security this way.

Due date. With 90 days usance from the bill of lading date of 10 November 2026, payment falls due on 8 February 2027. The importer must fund the account by then; otherwise the bank pays and the amount becomes a devolved, fund-based liability, which a credit officer treats very seriously.

How banks size an importer's LC limit

A credit manager doesn't fix an LC limit by guesswork. The common working is:

LC limit = (Annual purchases on LC ÷ 12) × (Lead time + usance period, in months)

If the importer buys ₹12 crore a year on LC, the lead time from opening the LC to shipment is 2 months and the usance is 3 months, the limit works out to (12 ÷ 12) × (2 + 3) = ₹5 crore. The bank then checks that this fits with the fund-based working capital limit. When the LC bill is paid, the stock comes into the cash credit and counts in the drawing power, and the creditors on LC are part of the assessment under the MPBF methods. The purchase figures themselves come from the borrower's projections, which is why errors in CMA data flow straight into the LC limit too.

Common discrepancies that delay payment

In practice, banks see the same few problems again and again:

Late shipment, or documents presented after the presentation period or expiry.
Invoice amount above the LC amount (beyond any tolerance) or goods description that conflicts with the LC.
Bill of lading not "clean", not "on board", or not made out as the LC requires.
Insurance cover lower than required, or dated after shipment.
Missing documents, wrong number of originals, or missing signatures and endorsements.
Names and addresses that conflict between documents.

For exporters: treat the LC as a checklist. Ask for amendments as soon as you receive it if any clause can't be met, and prepare documents with time in hand before the presentation deadline.

For importers: keep the LC simple. Every extra document or unusual condition is one more chance for a discrepancy, a delay and charges for both sides.

Frequently asked questions

Is a letter of credit the same as a bank guarantee? No. Under an LC, the bank pays when the seller performs and proves it with documents. Under a bank guarantee, the bank pays when the applicant fails to perform. An LC is a payment tool; a guarantee is a fallback.

Can an LC be cancelled once it is issued? Not on the buyer's say-so. Under UCP 600, credits are irrevocable, so cancelling or amending one needs the agreement of the issuing bank, any confirming bank and the beneficiary.

Does the bank check the quality of the goods? No. Banks examine documents only. If the buyer wants comfort on quality, the LC should call for an inspection certificate from an agreed agency.

Is an LC a fund-based or non-fund-based limit? It is non-fund-based when opened. It becomes a fund-based exposure only if the bank has to pay and the importer has not provided funds, which is called devolvement.

Sources

ICC Uniform Customs and Practice for Documentary Credits, UCP 600 (Articles 3, 4, 5, 7, 8, 14, 16, 30 and 38): library.iccwbo.org
ICC Banking Commission opinion on the five-banking-day examination period: library.iccwbo.org